(Download a .pdf version of this letter here.)
September 30, 2008
Dear Friends:
The House of Representatives "threw a curve ball" at investors yesterday, as the House voted 228 to 205 against the Troubled Assets Rescue Plan (TARP). This piece of unexpected news drove the Dow Industrials down more than 500 points in a matter of minutes. By the close on Monday, the Dow Industrials were down 6.98%, the Dow Transports 5.20%, the NASDAQ Composite 9.14% and the S&P 500 8.79%. Weakness was broad-based, as all ten sectors of the S&P 500 declined. Not surprisingly, the S&P 500 Financials index suffered the largest decline, closing down 16.01%.
To put things in perspective, this was the fifth worst day in the market in the last three decades:
- October 19, 1987: -22.61%
- October 26, 1987: -8.04%
- October 27, 1997: -7.18%
- September 17, 2001: -7.13%
- September 29, 2008: -6.98%
In our view, the $700 billion TARP was and is still necessary to bring more order to the current vicious cycle of selling and deleveraging in not only the US financial sector, but the global financial sector. The structure of the TARP may not be ideal, but the dangers inherent in the credit and banking system need to be addressed with effectiveness rather than political expediency.
This vicious cycle of deleveraging - which accelerated when Lehman was allowed to file for bankruptcy - engulfed Wachovia, Fortis in Europe, and Bradford & Bingley in the UK over the weekend. If Morgan Stanley and Goldman Sachs had not filed to become bank holding companies by last Thursday evening, chances were high that at least one of them (i.e. Morgan Stanley) would also have filed for bankruptcy (or sold for a song) by Monday morning. With the latest equity injections (and significant confidence booster) into Goldman and Morgan by Warren Buffett and Mitsubishi UFJ, respectively, this issue is off the table, for now. However, if Congress does not pass the TARP soon, this could again snowball into an uncontrollable crisis. Already, news is coming in that Dexia SA, the Belgian/French based institution that is the world's largest lender to local governments, was given a US$9.2 billion lifeline by the French and Belgian governments. This rescue will be in the form of an equity/convertible bond investment. While this will be dilutive for existing shareholders, it is interesting to see that neither the French nor the Belgian governments are doing this deal at severely punitive terms. With the majority of the US financial sector still being demonized and existing equity holders of troubled institutions being obliterated, I doubt a rescue resembling Dexia’s will fly in the US anytime soon. Lost in the noise of the banking crisis, it is important to note that Congress did quietly pass a bill that will provide $25 billion in low-interest loans to our "Big 3" automakers.
Aside from more cash injections into the global banking system and money markets, neither the European Central Bank nor the Bank of England has moved to lower interest rates thus far. With crude oil now trading below $100 a barrel, copper below $3 a pound, and with "second-round inflation" effects now quickly dissipating around Europe, it is now much more prudent for both the ECB and the Bank of England to cut rates as opposed to adopting a neutral policy - even though both central banks have a strict inflation-fighting mandate. Should the global financial markets remain strained going into the ECB's policy meeting on October 2nd, we would not be surprised by a cut of at least 25 basis points during that meeting. On the contrary, we would be quite surprised and disappointed if the ECB does not at least adopt an easing bias. As for US monetary policy, Fed Funds Futures are now discounting approximately 44 basis points of further easing by the end of this year.What is the likely outcome of all this tumult? In our view, the combination of the passage of the TARP and the possibility of a round of coordinated rate cuts by the ECB, BoE, and the Federal Reserve should serve as a significant confidence booster for the world's equity and credit markets. Another global factor to be considered is the increasingly important role for China in world capital flows. The People's Bank of China too, will need to continue to ease monetary policy, as the Chinese economy is now slowing dramatically on the heels of a significant weakness in real estate prices/construction and the general lack of credit availability. We suspect that the market will rally given any sort of news regarding monetary easing from any of the central banks we have mentioned. Whether any global equity rally will be sustainable will depend in large part on the policy actions from the ECB, the BoE, and the People's Bank of China going forward.This too shall pass. Valuations by many measures are now at their most attractive levels in at least 15 years. Many corporate balance sheets retain significant cash and could well utilize weakness in the capital markets to buy back stock or to make acquisitions. The passage of the TARP or similar legislation will be an immediate confidence booster to the global markets. Hopefully, the dramatic 777-point decline of the Dow yesterday was sufficient to change the minds of those in the House. If not, the failure to take political action at a time of great need will go down as a policy blunder and failure of leadership on par with the Smoot-Hawley Tariff Act of 1930.As always, we appreciate your trust and confidence in us and welcome the opportunity to serve you in addressing your concerns.
Sincerely,
Richard H Konrad, CFA, CFP®
